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February 06, 2011

Yet another look at cost inflation

Why Is This So Hard To Grasp?

I am continually amazed to hear some economists say that energy costs should not have that big of an effect on the economy. What they do is take a look at a typical cost structure for a typical company that shows that energy costs are a small part of the total cost of operations. In a recent attempt to show how costs at each stage of production build up with energy inputs I wrote “Energy costs and the economy”. Then I get this e-mail from a reader who is trained as an academic economist:

You continue to make the mistake of thinking that energy cost are the only important factor in the supply chain costs. Companies pay out far more for materials, labor, and services than they do for energy. Take a look at any typical company's cost structures and you will see that this is the case. Basically, I think computer scientists should stick to computer programming and leave the economics to experts.

Ironically, this reader apparently thought my systems science work was spot on based on comments s/he sent me, but takes serious exception to my dabbling in economics (and being somewhat derogatory in my comments about neoclassical economists!)

OK, maybe I am meddling in areas in which I have no business. But what is going on in the economy seems so astoundingly obvious I just cannot grasp how somebody with a modicum of education can't see this.

The figure below is yet one more attempt to demonstrate the relationship between energy flow and economic activity, and especially the costs of things. In this figure I focus on a supply chain model but in a graphical form (as opposed to my cost accounting model from the blog “What's wrong with this picture?”). Note that at every stage of production there is one common factor that is consumed in the process and that is energy, either in the form of fossil fuel, electricity, or human labor. And the company has to pay for all of those inputs. What is more subtle is the fact that materials purchased from processes earlier in the chain have what is called embodied energy in them in the sense that energy was expended to shape or construct them into the form that is supplied to the next stage. ALL value added comes from work done to make stuff for the next stage up in the chain on the way to the consumer. And that work is accomplished ONLY with energy being expended. Period.

Figure 1. Energy flows into every single process stage in a supply chain. Energy is consumed in the process and leaves the system as waste heat according to the Second Law of Thermodynamics. Materials are worked on at each stage and the embodied energy is equivalent to reduced entropy (the material becomes more usable and valuable at each stage). Money flows in the exact opposite direction of energy showing that money is essentially a message that is employed to direct what work should be done. The money arrows from consumption and extraction do not have a defined target. These may represent externalized costs that are not being paid in real time, but will need to be paid eventually. Not shown are waste materials emitted by each stage in the chain.

What this graphic is attempting to show is that the only real cost item that means anything is the accumulation of embodied energy going into the final product plus the energy used up in the consumption of the material good. The final product production process also shows that there are multiple supply chains that need to be accounted for. This is actually the case for each of the previous stages as well, meaning that a more complete picture would look like an inverted tree with many lower level nodes feeding into the higher level nodes.

At each stage in the chain energy inputs are used up. Most of these come from fossil energy (with a few coming from hydro and nuclear for electricity). Labor, that ultimately depends on fossil fuel inputs to agriculture, is another energy input not really accounted for in the energy bookkeeping. In truth, labor inputs require much more energy than just from agriculture. Every worker has to obtain enough money (wages) for their labor to also pay for the energy they consume in products and services and not just for food. One of the reasons that American labor has essentially priced itself out of the global market is that the energy requirements for a typical middle-class American (family) are so high that producers perceive that they are not getting their dollar's worth out of the labor (work) that gets done by American workers. Ergo, they seek cheaper labor markets off shore to re-balance the costs inputs..

In every case, however, the costs that are building up through the supply chain all have their basis in the energy consumed at each stage. While prices charged for any given item or service might temporarily exceed the cost plus ordinary profit level, competition among suppliers (of non-proprietary goods/services) will tend to bring that down to some norm. Thus the cost build up in any final product from raw material to the finished good is entirely a matter of energy expended and represented in the value added aspect called embodied energy.

The Price of Oil

So once again we come back to the impacts of oil prices on the general economy. Over eighty percent of our energy comes from fossil fuels. Ninety percent of transportation and extraction energy comes from oil. In addition both oil and natural gas are feedstocks for pharmaceuticals, plastics, and agricultural products such as fertilizers and pesticides. Oil is needed, in the form of diesel, to extract coal, so as much as ninety percent of the energy we get from coal-fired boilers is touched by oil in some fashion or another.

And the price of oil is trending ever upward just due to fundamentals of supply and demand. The world is still growing in absolute numbers of humans. A number of developing economies are growing in their per capita use of fossil fuels. China and India are huge economies with huge appetites that are starting to have a significant impact on demand. Meanwhile the non-OPEC producers of conventional oil are going into decline worldwide. OPEC countries, especially Saudi Arabia, are still claiming they have ‘spare capacity’ that they can bring on line to compensate for increased demand, but so far we haven't seen much evidence to give us confidence in those claims. Indeed the overall production rate of global oil appears to be going down. The upward pressure on prices is evident from the price trend for all of the major benchmark oil markets.

At the same time the cost of extracting oil has been going up as well. More cogently, the amount of energy that must be expended to get the next unit of oil energy has been going up meaning that there is actually less net energy to be used for other economic work. I and a number of other biophysical economists (oh, I forgot, I shouldn't call myself an economist!) are reasonably convinced that the problems with the global economy since the meltdown in 2009 are largely due to the rapid decline in net energy that is actually reflected in the prices for energy and food (which is energy). Those are having a major impact on the whole economy especially since the modern economy is so much based on consumption.

We predict that as long as net energy is in decline, and that will be as long as we are dependent on increasingly expensive fossil fuels, prices of all goods will catch up. Producers will try mightily to keep from raising their prices as all cost components of their production inch upward. But eventually they will have to cover those costs even if their profits are squeezed. They can't afford to lose customers and will, individually, be afraid that some competitor will have a cost advantage and under bid them in the free market. But as the graphic suggests, no one will be immune from general cost increases. They will have to eventually raise their prices and everyone will feel it. And please note that I am talking about absolute purchasing power, not just the nominal prices. Regardless of monetary policies that might affect the prices in the economy, each person's capacity to afford consumption is going to go down.

Paying more at the gas pump is one thing. That one is pretty easy to understand since oil is the major component of gasoline, so you would expect more expensive oil would translate into more expensive gasoline. But as I sincerely hope you (especially you economists out there) now understand, the only real basis for costs and cost increases is the price we pay for fossil fuels. And until, or unless, someone comes up with a magic bullet in alternative energy production that matches fossil fuels in power production, and the cost of which does not depend on oil (fat chance), we had better get used to increasing prices everywhere we look and for a long time to come.

Comments

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Teeeeeny little point, but I love it that Mr Academic Economist has a little "problem" with subject-verb agreement..... But I guess academics don't have to pay attention to grammar. So I reckon that he is both logically deficient - as in presenting an erroneous argument - but grammatically deficient as well. Leaving economics to the "experts" is what got us into the shit bin that we are in.

Other than Steve Keen and biophysical economists, I've never seen any even know what a differential equation is. In fact it's so bad that Steve Keen starts his talks off by showing his model and then saying, "Don't worry, these are called differential equations and I just put them up to scare the economists in the room."

One time I thought Krugman had an equation that had dt in it but it turned out that d and t were actually just variables and that it was a coincidence.

Neoclassical economics is basically just massive curve fitting to "derive" Laws and then tortured explanations about why we observe the data we do. We are told that they are on par with scientific Laws, except scientific laws don't stop working every few decades.

On the other hand systems theorists can explain the economy through first principles and accurately describe what is seen both in "normal" times and "crises." The latter of which are literally mathematically impossible in neoclassical economics which is why everything that doesn't operate according to the model is deemed to be exogenous.

Using neoclassical logic, I propose Mikkel's Law which simply states "Mikkel is always right at probability of 80%." We know that this is a Law worthy of being called as such because a)I can provide data that on past performance that when fit shows a r^2 of 0.8 and b) it is simple, so therefore it must be true. I will personally guarantee that this Law is Reality and any time that it appears that it fails it's actually because of unexpected exogenous causes that I can't be expected to know about because they are unpredictable. Any time that an exogenous event happens it may create a string of times I'm wrong that appear to violate the normality assumption, but these will all be accounted eventually so there is no point in questioning it. We should obviously follow Mikkel's Law and allow me to set all policy, then when I die or become enfeebled we will let market forces find a replacement Mikkel or perhaps transition to George. It is important that we do not interfere with this process though, because Mikkel's Law says we shouldn't.

BTW there are three GREAT charts here that show how markets interact with resources, manufacturing and marketing. Charles' work is far superior to my ranting above perhaps because he isn't trying to use the mind numbingly obtuse logic of neoclassical economics.

Gail has a great post on how ignoring the physical realities of how systems are integrated can create very sudden cascades of failure. Her point focuses on electricity generation but the same concept of local over-optimization damaging network resilience is exactly how to describe the financial collapse and the current explosion in food prices.

These examples also show that ironically the fact that energy currently makes up a small percentage of current costs means that we are more susceptible to widespread economic cascades due to energy prices rising permanently than if we currently had a large percentage of cost go to energy already.

I think this article is spot on. How about another way of looking at the same problem? Show us something that Oil/Energy "doesn't" play a role in (that we consume). Energy is at the core level of everything we as humans do. The second law of thermodynamics comes to mind here. We've already hit peak oil, what happens from here on out is pretty simple even for the non intellect to grasp - as things become more scarce the price goes up.

George,
I continue to attempt to communicate with you, but I'm beginning to wonder why. You go on and on at such great length, year after year, completely ignoring superseding findings that would **give your own thesis** a far more valid basis and much wider implications. It seems you don't expect it, so you refuse to consider it. What should I do with scientists like you, behaving just like TS Kuhn described as "what scientists never do us adopt a new paradigm".

The embodied energy of business operations is physically 500% larger(nominally)than even the most careful efforts to trace energy uses to business will show. The untraceable energy uses that businesses employ don't leave receipts. It's a very cool finding. Why don't you even mention that a scale change in energy use assessment may be needed.

The fact is that the standard method you use to "show how costs at each stage of production build up with energy inputs" should be multiplied by 500%, as a first step, to show the importance of doing the systems analysis correctly using whole system methods. The self-managing production services that businesses employ don't leave receipts for their energy uses, that's why they've been untraceable.

You keep claiming to correct everyone else while yourself still only counting traceable energy uses, and the "whole technology" method that ignores that technology can't work without operators. As whole systems businesses are matched pairings of "controlling and controlled parts", "animate and inanimate", "operators and machines", and **BOTH** have embodied energy costs. I wrote a long paper on the subject, about to be released in Sustainability, and have mentioned it to you several times. http://www.synapse9.com/pub/SEA_EROIwind.pdf

It doesn't help science for every individual scientist to live in their own personal ivory towers of self-reinforcement. How do we go about changing that?

Phil, can you plainly state the implications of your statement that George disagrees with?

For me the whole embodied energy fact makes me very cynical. It is easy to show that the flow based energy that our systems require will be nearly impossible to meet going forward and I also believe that it is possible to construct new systems that reduce the flow based energy needs to manageable levels.

However, even assuming that's correct then the amount of embodied energy needed to produce those new systems is mind boggling.

Oops. That is my mistake, not his/hers! I didn't copy the text properly. It should have been "factorS" rather than "factor". My bad! The person I am alluding to is actually quite intelligent and well educated. So no aspersions based on improper grammar can be attributed!!!!

Think content.
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Now now, Mikkel. Charity. It takes time and an ability to question everything to shift one's perspective! Give them time. After all, Kahneman was able to get out of the mold and won a prize in honor of Alfred Nobel as a consequence!

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Mr. Cranstone,

That is a worthy challenge. Anyone would be hard pressed to show something that wasn't touched by oil. And certainly it would be physically impossible to show some human activity not dependent on energy!

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OK Phil, I am chagrined.

To be blunt, I have read some of your work at synapse9 and I must be dense. I just don't understand a lot of it. I can't be expected to cite references that I do not grasp.

Also, please note that this is not a scientific journal but a blog. I write here to express my own views which may or may not be based on prior scientific research.

If you have a position to proclaim based on your own research, please feel free to express it here as you see fit. But do not chastise me because I don't liberally cite your work. I've provided readers with a link to your blog and they are free to examine your arguments as much as they want.

If I understood your points of view and they, in fact, bolstered my arguments here, I would cite you as much as I do any one on this site.

So please don't chastise me for not incorporating your research into my own visions. I do not edit or moderate anyone's views here and you are welcome to state your case as you desire.

George, I do not hold any malice towards any individual neoclassical economists. OK that's not true, there are a few that I do because they did things like actively hold up Pinochet and Franco as the Ideal; and then there is the whole Wall Street complex where they gave academic cover (and then received millions of dollars) to a system that encouraged wide scale fraud that continues to this day. So I hold something against those particular individuals but not in general.

That said we are suffering through an immense economic crisis that completely invalidates everything that they hold dear. Not only are they not chastened but they refuse to listen to their colleagues such as Stiglitz and Keen that have warned of the problems of neoclassical economics for decades. Not to mention people like Bill Black and Elizabeth Warren. I'm highlighting these people because they are relatively orthodox compared to bioeconomists and with the exception of Keen have top notch pedigrees.

It's not just that they are wrong; I am wrong far too often to hold that against anyone. It is that they have more influence than any other intellectual group (save lawyers) and have Bad Thinking: the logic is so absurd and anti-empirical that to maintain their tortured rationalizations in the face of immense suffering caused by their proclamations is repulsive. Especially when the great minds above are being marginalized in influence.

I am a big fan of Kuhn's framework for paradigm shifts. The way I look at it there is -- uh, shall we say "ample" -- evidence that the neoclassical paradigm is flawed and should be replaced by one of the competing ones. Per Kuhn's observation (and paraphrasing Planck, "Science advances one funeral at a time") I don't really hold out much hope of convincing its adherents. Instead I view it as a battle in the middle and towards the young. In that aim scathing bluntness about the core axioms of the field can be an asset and defenders of it are free to challenge the exact details if they feel the generalizations are unfair.

So I try to hold charity towards all, but this is really a struggle. Neoclassical inspired policies that have pushed for global monoculture, segmentation and consumerism are the proximate cause for many of our ills (although I obviously think the theory itself is just a symptom of deeper human proclivities) and it's hard to me to bite my tongue when they blather self serving idiocies in the face of mass suffering. I pray that if I'm ever unfortunate enough that anyone listens to me I retain the humility needed to accept responsibility for my miscalculations and seek wisdom in those that had compelling disagreements.